Markets & Finance

China Stocks: Waiting Out the Bubble

Gene Sit of Sit Investment Associates says once the hot market cools down, a soft landing will make many stocks attractive

Like many pros, Gene Sit thinks China's stock market is ready to burst. But he figures the damage won't go deep.

That's because the sparks for China's booming economy—including a high savings rate, strong trade, and growth in real estate and the building of roads and other infrastructure—won't go away, Sit says.

The 69-year-old chairman of Minneapolis-based Sit Investment Associates, which manages about $7.7 billion, knows better than to bet against a burgeoning country like China. Sit was born there, and at age seven was kidnapped by Chinese gangsters and held hostage for nine months until a ransom was paid. After his family's wealth had been wiped out, he joined his father in the U.S. in 1948, learned to speak English, and later studied finance.

Since 1979, Sit has met regularly with Chinese political and business leaders to discuss the economy and analyze investment opportunities. Now the father of six (five of whom work at his firm) is gearing up for his next trip to China in November, and he plans to attend the Olympics next summer.

Three of Sit's funds hold Chinese stocks. Through Sept. 30, the Sit Global Fund had a net return of 15.9% in the last year, and 23.6% annually for the last three years. The Sit Developing Markets Growth Fund surged 56.2% for the one-year period and gained an average of 39.34% a year for the last three years, beating the MSCI Emerging Markets Index. And the Sit Pacific Basin Fund ran up 31.2% in the last year and 25.1% for the three-year period, outperforming the MSCI AC Pacific Growth benchmark.

BusinessWeek.com's Karyn McCormack spoke with Sit on Oct. 17 about how he's navigating the China market. Edited excerpts from their conversation follow.

You say China's A-share markets are in a "bubble stage," but the aftermath should be "containable." How bad could it get?

China's market could have a correction because of valuations and a lot of speculation. In Shanghai you can now find shoe-shine boys buying stocks (BusinessWeek.com, 3/19/07). The market is up 125% this year.

The Shanghai A-share index [which tracks stocks restricted to Chinese investors and qualified institutional foreign investors] has a p-e of about 65. But earnings are expected to grow 20% next year, which brings the p-e to 45—this is where the index was when we started the year. The index was around 2,800 at the beginning of the year and then went to 3,200 before it corrected to around 2,900 in early March. Now we're up to 6,300.

A soft landing to us means a correction to about 5,300—so 1,000 points, or around 15% below where we are now. That would bring the p-e to 35 on next year's earnings. If we're wrong and all hell breaks lose, you could see 4,500, or a p-e of 30.

Why do you think the damage won't be too bad?

We see a soft landing because we think fundamentals will continue to be good. China's GDP might not be 10% to 11%, but it might be 8% to 9% after the summer of 2008. That's because China now has the money, with growing reserves, and the trade numbers continue to be quite favorable. The government has the resources to build the country's infrastructure, and it can improve living and environmental conditions. Plus, the savings rate is very high, and corporations are making money.

So the stabilizing factor is good economic growth with an abundance of liquidity from consumers' savings.

What are the main risks for China's market?

Inflation could throw us off. Food inflation is about 10% now. If it keeps going up, interest rates might have to be tightened. A lot of money has gone into real estate, and some of the froth is coming out.

But in the end, fundamentals will support the market. The fundamentals in China are a lot better than Japan post-'89. Japan's stock market went from 39,000 to 14,000. That would happen to China if inflation got out of hand, the economy tanked, and there was social unrest. I don't see that happening. I think the government will move the country along.

Which sectors hold the most promise for the long run?

For the longer term we like the infrastructure companies that are involved in water supply, air quality, and pollution control. We like the consumption sector, which includes education, travel, leisure, and consumer staples. Consumption is 35% of GDP in China, vs. about 70% of GDP in the U.S. This will increase as China's economy grows. We continue to like telecommunications. We also like energy.

In financial services, we own China Life (LFC). In the infrastructure area, we own China Communication Construction. In telecom, we have China Mobile (CHL). And in energy, we own PetroChina (PTR), which Warren Buffett has been unloading; CNOOC (CEO); China Oilfield Services; Xinao Gas Holdings; and Suntech Power Holdings (STP). We also own a utility, China Water Affairs Group.

Are you buying any Chinese stocks now, or are you waiting for the widely expected decline to pass?

In our aggressive portfolio, we have to be there. In our international portfolio with large-cap names, we're waiting, doing our work, and trying to be price-conscious.

What's the best way for U.S. investors to play the economic growth in China?

Buy the H shares listed in Hong Kong. We mentioned some of them—CNOOC, China Mobile, China Life, and PetroChina. This is still the way to go because transparency and liquidity are important. There's too much euphoria now and the market will have its day.